LLSV (2000b) show that countries with strong shareholder rights are able to force firms to disgorge cash and pay higher dividends. They find that dividend policies vary across legal regimes in ways consistent with a particular version of the agency theory of dividends. Specifically, firms in common law countries, where investor protection is typically better, make higher dividend payouts than firms in civil law countries. Moreover, in common but not civil law countries, high growth firms make lower dividend payouts than low growth firms.

Using panel data on a sample of Australian publicly-listed firms over the period 2000-2005, Atmaja et al. (2007) test whether stronger legal shareholder protection and higher levels of private benefits of control induce controlling families to expropriate minority shareholders wealth via retaining the cash flow within the firm. They employ a random effects regression to minimise spurious relationships between dependent and independent variables. Their analysis indicates Australian family firms pay higher dividends and employ higher debt levels than their non-family counterparts, which suggests that they could not expropriate minority shareholders via dividends and debt.

These results support the version of the agency theory in which investors in good legal protection countries use their legal powers to extract dividends from firms, especially when reinvestment opportunities are poor. This ‘outcome model’ subtends with the opposite direction substitute model. The substitute model suggests that strong shareholder protection reduces the role of dividends in controlling agency costs, leading to a decrease in dividends.

This model is supported by Easterbrook (1984) who suggests that dividends may mitigate agency costs by increasing the firms’ reliance on external financing and hence subjecting firms to outside monitoring. This implies that dividend policies and alternative corporate control technologies may be substitutes. Another explanation by Jensen (1986), when a payout takes place, cash reserves fall, and corporate insiders can use a lower amount of freely available cash to pursue private interests.

Liu (2002) examines dividend policies based on a panel of more than 2,300 firms from 22 emerging economies during the years 1986-1998. These countries have carried out modifications in three aspects of the corporate governance system, including shareholder legal rights and financial disclosure. Even though the cross-sectional evidence seems consistent with the outcome model in that economies with better shareholder protection have higher dividend payout ratios, once the time-series dimension is added, the substitute effect dominates the outcome effect: improvements in shareholder legal rights, stock market discipline and accounting disclosure are associated with both lower cash dividend ratios and lower sensitivity of dividends to free cash flow.

The empirical evidence reported in this section, along with the previous sections, clearly indicates that, although the finance and law theory has some validity, there are several criticisms and shortcomings that can be made of this work which has implications for the aim of this thesis.